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This week Buddhika Piyasenna, head of Fitch's Energy and Utility Ratings in Asia Pacific, spoke with two of Fitch's thermal coal analysts, Monica Bonar in New York and Shahim Zubair in Singapore, about the outlook for the Asian thermal coal industry including the impact of growing US exports to Asia. Piyasenna notes that the analysts do not expect thermal coal prices to increase substantially over the next two years, and the industry's financial profile is likely to remain weak. This, they said, has more to do with increased supply in Asia and China's lower economic growth rate, rather than the impact of US exports to Asia.

The analysts notes though that the long-term fundamentals for thermal coal remain intact, with populous emerging markets expected to consume higher quantities of coal to support growing electricity requirements.

Here’s a transcript of the interview:

Buddhika: Thermal coal prices in Asia have declined significantly from their peak in mid-2011. Shahim what do you believe to be the main reasons behind this and to what extent did higher thermal coal exports from the US in 2012 play a role?

Shahim: Slowdown in consumption growth and substantial new supplies coming on line from Indonesia and Australia during the first half of 2012 are the main reasons behind the recent slide in thermal coal prices in Asia. In addition, lower-than-expected growth of power demand in China - the largest importer of thermal coal - led to high stockpiles at power stations, postponing a price recovery. Furthermore, China started using more hydro and nuclear sources for power generation in 2012, resulting in thermal coal-based power generation output growing at a slower pace than overall electricity production growth in recent quarters.

Regarding increased US coal exports to Asia, we believe this has had a minimal impact on Asian coal prices. While thermal coal exports from the US to Asia have increased materially in percentage terms - some 50% in the first half of 2012- this is off a very small base of six million tons in 2011. Such quantities are still quite small compared with Asia's imports of around 600 million tons per annum.

Buddhika: Monica, what is the current situation in the US with regard to thermal coal consumption and how is this likely to evolve over the medium term?

Monica: Domestic coal consumption remains challenged by high coal inventories at power plants and high natural gas inventories. Should the winter be warmer than normal resulting in low residential demand for natural gas, natural gas will compete with coal in all basins.

Over the medium term, several older, less efficient coal-burning power plants are scheduled to close rather than incur the investment needed to comply with new environmental regulations. While we believe these plants represented about 10% of the 1 billion tons of annual coal consumption in 2010 they are only marginally used in the current environment of 825 million tons of coal expected to be consumed in 2012.
We believe that thermal coal production from the high-cost Central Appalachian region will continue to decline given substitution by natural gas and lower-cost coals from the Powder River Basin, Northern Appalachia and the Illinois Basin.

Buddhika: So is it likely that US producers will continue increasing their thermal coal exports to Asia and Europe?

Monica: U.S. producers from the Powder River Basin will continue to export modest amounts to Asia to retain footholds in the market gained while margins were higher. While the Powder River Basin producers are working to increase port capacity, they are facing significant headwinds from well-funded environmental groups.

Regarding exports to Europe, spot prices in the Atlantic Basin are not at levels that are attractive to U.S. coal producers, with the possible exception of those holding high inventories. Nevertheless we expect U.S. producers holding long-term contracts with European utilities to continue exporting.

Buddhika: How do the economics stack up for US thermal coal producers to deliver coal to East Asian markets competitively? To what extent are low sea freight costs important for this to work?

Monica: Rail-to-port costs are higher on a per ton basis than sea freight costs. Coal near barge transport is more competitive so some higher-cost coals are barged to the Gulf of Mexico and shipped to Asia. Powder River Basin coal has very low mining costs and can be competitive in the Pacific Basin in normal markets despite rail and ocean freight. Thermal coal has lower margins than metallurgical coal and port capacity tends to be optimised with this in mind especially during the shortage of metallurgical coal following the floods in Queensland Australia. Canadian coal terminals on the west coast were built to serve Canada's metallurgical coal exports to Asia and less than 5 million tons of Powder River Basin coal were shipped from there in 2011.

Powder River Basin producers are currently looking to expand port capacity in the U.S. Pacific North West but there is significant resistance from environmental groups and this is at least two years away and more likely five years away.

Buddhika: Shahim what is your view of thermal coal prices in Asia in the short- to medium-term? To what extent is production volume rationalisation helping the market?

Shahim: We believe that thermal coal prices have bottomed out. Although we expect prices to recover somewhat in the next 12 to 18 months, we don't expect thermal coal prices to substantially increase in the next three years. At current prices, a sizable share of production capacity is below marginal cost.

Accordingly, coal prices will be supported by production cuts by key Asia Pacific producers. We have already seen announcements by companies on reducing production from current levels or putting production expansion plans on the backburner. In addition, many start- up and high- cost mining ventures are under financial distress; we expect banks to lend very cautiously to the sector which will also help curtail excess production from these markets. Coal inventories are also normalising at power plants across the region.

Buddhika: Are you concerned about the financial health of Asian thermal coal producers and do you expect a negative rating action on any of the thermal coal producers rated by Fitch over the next 12 to 18 months?

Shahim: We expect financial profiles to deteriorate through 2013 for Asian thermal coal producers in general. Most established coal miners in Indonesia sell their products on long-term contracts, a material share of which have their prices fixed on an annual basis. The full impact of lower thermal coal prices will be felt in 2013 when contracts are renegotiated based on current lower prices.

That said, we don't expect any negative rating action on many of the rated Asian coal producers, which include PT Adaro Indonesia ('BB+'/Stable) and PT Indika Energy Tbk ('B+'/Positive). These operators benefit from low-cost mining operations that allow them to generate sufficiently strong cash margins despite current low prices. However, our universe of rated coal producers is not a full representation of the industry; we expect a large number of coal miners to see financial stress under current and forecast prices in 2013.

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